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The Finance Minister has mooted a proposal to levy greater taxes on the rich. To understand the efficacy of this proposal, let us examine the evidence provided by careful academic research with respect to such efforts in the past. Since authentic data on the rich and their money is hard to come by for India, I will rely on the evidence generated through careful research in the U.S. Tax compliance in India is significantly worse than in the U.S. Therefore, it is reasonable to assume that the gains to the taxpayer from taxing the rich in India would be at most as much as the gains from doing the same in the U.S. If the gains from such a step are not significant in the U.S., then it is unlikely that the gains would be large in the Indian context.

The conceptual argument against levying greater taxes on the rich centers on the greater inefficiencies generated by the same. People with high incomes are usually more responsive to tax changes than people who earn less. The rich have greater discretion over the form their income takes —salary, stock options, non-taxable perks, capital gains and dividends— than the middle- and lower-income groups who depend primarily on wages and salaries. High-income individuals can choose how they will receive their taxable income and how they want that income to be labeled, enabling them to reduce their tax bills. Raise taxes on the rich, and the rich will respond by cutting back on efforts to bolster their businesses and their own incomes. This damages the economy, hurting both rich and poor.

Moreover, high-income people respond to changing tax rates by reporting less income and hiding their income in tax havens. If there is a big response of rich people to taxation, it means that a progressive tax code is extremely expensive. It may not generate a lot of revenue, but it leads people to put their money in inefficient forms or spend their time hiding their money, rather than doing things to help the economy. If you lower tax rates for the rich, they will not hide their money; they will work harder, invest more, and ultimately generate revenue. Everyone will benefit.

Does the above conceptual argument stand scrutiny? To examine the same, consider the effect of the tax increases by Bill Clinton, who was elected president in 1992 with the promise to raise taxes on high-income Americans. In 1993, U.S. Congress raised the marginal tax rate from 31 percent to 39.6 percent on income greater than $250,000. How did the rich respond to this increase? Research by Austan Goolsbee of the University of Chicago Booth School of Business* shows that upon hearing of the tax increase in 1992, the wealthy ran for cover, and taxable income fell significantly in 1993.

The increase in tax rates lead to a substantial increase in the exercising of options in 1992 followed by a dramatic decrease in 1993. The majority of this action was concentrated among executives at the top of the income distribution. They simply juggled their income between years. Between 1991 and 1995 the average taxable income of the top 10,000 executives at American firms equaled $852,000 in 1992 dollars. Although these executives made up only 1 percent of America's one million highest-income taxpayers at that time, they accounted for 21 percent of the total change in the taxable income of that group after the 1993 tax hike. Although there was a pronounced decline in taxable income after the 1993 tax hike, this decline was a temporary shift in the timing of compensation. According to the data, high-income executives saw their average taxable income drop significantly from 1992 to 1993, falling by $179,000, or almost 16 percent. But looking more broadly at 1991 to 1995, however, this 16 percent drop followed a tremendous rise of 27 percent, or $242,000, from 1991 to 1992. In addition, the 1993 drop was not sustained. In contrast to this large response in taxable income of executives getting stock options, executives without stock options showed six times less responsiveness to the changes in the tax rates.

Thus, the significant responses to the increase in the tax on the rich in the U.S. were short-term responses. However, over the long run, taxing the rich generated about the same inefficiencies in the U.S. as taxing the middle class or anyone else. About 1/4 of the revenue generated from rich people's taxes is burned in inefficiency, and that's almost exactly equal to the inefficiency generated from taxes on other strata of society.

Given the fact that the net effect of the tax increase (taking into account the short-term and long-term responses) was not significant in the U.S., whether such a step would be fruitful in India remains a big question. In the Indian context, given the significantly lower tax compliance, the short-term losses may not be offset by long-term gains as it happened in the U.S., which suggests that the net effect may indeed be negative. Caution is, therefore, warranted as the finance minister mulls over this step.